A Flaming Buy? Natural Gas Won't Stay Low Forever

There are two kinds of investors: those who run away from a fire and those who run toward it.

ENLARGE

Christophe Vorlet

To invest in natural-gas stocks, you had better be the kind who runs toward a fire.

Prices have collapsed—for natural gas and for the shares of companies that produce it. Every day, the U.S. natural-gas market is flooded with an average of 3 billion cubic feet more than the nation consumes. Shares of gas companies are down—in a rising stock market—by an average of 22% over the past year. Even Warren Buffett lost money when natural-gas prices fell further and faster than he expected.

In short, the news about natural gas is awful—exactly the type of conflagration that growth investors hate, but value investors love. "Everyone who has a brain should be thinking of how to make money on this in the longer term," the renowned investor Jeremy Grantham of GMO wrote recently.

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In mid-2008, natural gas traded above $10 per futures contract; today you can buy the equivalent for $2. The fuel is so cheap that if you could somehow magically transport it to Europe or Asia, you could sell it for four to eight times what you paid for it here.

New discoveries and innovative drilling techniques, along with the recent balmy winter, have led to a vast oversupply. Nationwide, inventories have risen 56% over the past year, according to the U.S. Energy Information Administration.

The market is so awash in natural gas, according to many analysts, that there could be no space left to store the stuff in the entire U.S. by this autumn unless demand surges or producers seal their wells.

Charles Maxwell, an energy analyst at Weeden & Co. with 45 years of experience, says, "I cannot in my memory recall a time like this, when we have created a surplus that may be beyond our capacity to store."

Historically, says David Tameron, an analyst at Wells Fargo Securities, natural gas has been about 10 times cheaper than crude oil. At today's depressed prices, gas is roughly 50 times cheaper. "That discount is enormous and unsustainable," he says. "If you look to the future of the U.S., the free market will turn natural gas into the answer for this country's energy problems."

In what could be a multiyear shift, electrical utilities and trucking companies, among others, are already switching from coal or diesel to natural gas—and more industries are bound to follow if it stays cheap.

Eventually, the rise in demand is bound to drive prices higher. Then the profitability of the companies that discover and produce natural gas will heat up.

"Investors can make big money longer-term," says Dan Rice, co-manager of the BlackRock Energy & ResourcesBGR-0.64% fund, "but you tell me how many people have horizons longer than three or six months."

ENLARGE

Range Resources and Encana are among the natural-gas producers analysts like. Above, pumps used to release natural gas at a Range Resources site in Claysville, Pa.
Associated Press

Mr. Rice likes Range Resources,RRC-1.28% a Fort Worth, Texas-based producer with broad exposure to the "sweet spots," or rich fields, in the Appalachian region that produce gas at very low cost. That should enable it to survive a prolonged period of depressed prices for gas.

Range is one of the few natural-gas plays to have gone up over the past year, but its profits are so depressed that the stock is trading at a triple-digit multiple of earnings. Still, Mr. Rice estimates the company's assets are worth up to $200 per share.

Mr. Maxwell is a fan of Encana,ECA-0.65% an Alberta-based producer whose shares are down 36% over the past year. The company is trading at slightly under its book value, or the surplus of what it owns over what it owes, and at four times its cash flow—making it statistically cheap on two key measures. Much of its gas reserves are in northern Canada, a potentially rich source that Mr. Maxwell calls "one of the greatest gas plays of the coming 30 years."

If you can stand not just risk but controversy, you might even consider Chesapeake Energy.CHK-3.46% Its chief executive, Aubrey McClendon, borrowed more than $1 billion to take direct personal stakes in the company's wells. After these arrangements were widely criticized (and the stock fell 27% in the past month), Chesapeake said they won't be renewed.

A tattered stock in a battered industry, Chesapeake recently traded at three-quarters of book value and less than four times cash flow, according to Standard & Poor's. The company has extensive holdings in gas-rich shale, analysts say. Chesapeake has lots of debt and not much cash. It's an extra-risky bet that natural gas will rebound sooner rather than later.

Don't touch these stocks unless you can withstand the high probability of getting a short-term scorching. There's also a lesser risk that some of these companies could flame out completely. Investors here need patience, deep pockets and an implacable tolerance for pain.

This looks like a great way to invest. I myself used a program called Microcap Millionaires to start investing in small cap stocks and it has been working great. It is no pump and dump scheme but honest advice from an expert in the field. http://microcapmillionairesreviews.org/

The single limiting factor for almost all independents in the Natural Gas universe is their balance sheets. There's a healthy level of debt across the board, and most of the companies have budgeted to spend all of their cash flow; some even more. That's not only limiting, given lower than expected cffo, they're accumulating additional short term debt.It's very possible that the equity in a number of these companies could be severely diluted or wiped out, if the low prices continue. That said, on a cost per equivalent btu, they're historically very cheap.

The enormous market awaiting natural gas is to convert natural gas to methanol as a transportation fuel. That market could potentially be a large fraction of all the natural gas produced, could raise and rationalize the price of natural gas, and greatly benefit almost everyone outside OPEC.

The transportation market for natural gas is tiny now and can be huge with conversion of natural gas to methanol. The MIT White Paper, “Methanol as an alternative transportation fuel in the US: Options for sustainable and/or energy-secure transportation” found methanol “is a liquid fuel which can be blended with gasoline and ethanol and can be used with today’s vehicle technology at minimal incremental cost. THERE ARE NO TECHNICAL HURDLES. [Emphasis in the original]. . . . The “methanol economy” in the US has the potential to substantially decrease energy dependence, providing energy security using domestic feedstocks and labor, with substantially lower footprint to the environment ([Green House Gases or] GHG), with a product that seems competitive in the present markets.” At P. 25, that report says, “Assuming that 10% of the gasoline consumed in the US is replaced by methanol (approximately 28 billion gallons of methanol per year), the time to exhaust the proven reserves of . . . natural gas is” 429 years including shale gas.

The key policy to open this market to natural gas is the H.R. 1687, the Open Fuel Standard. As a Major Recommendation on P. 127, MIT’s comprehensive report on The Future of Natural Gas said, “The U.S. government should implement an open fuel standard that requires automobile manufacturers to provide tri-flex-fuel [methanol, ethanol, or gasoline, or mixtures of them] operation in light-duty vehicles. It should also consider methanol fueling infrastructure subsidies similar to those given to the fueling infrastructure for ethanol.” At P. 11, it said, “Energy density, ease of use and infrastructure considerations make liquid fuels that are stable at room temperature a compelling choice in the Transportation sector. The chemical conversion of natural gas to liquid fuels could provide an attractive alternative to CNG. Several pathways are possible, with different options yielding different outcomes in terms of total system CO2 emissions and cost. Conversion of natural gas to methanol, as widely practiced in the chemicals industry, could provide a cost-effective route to manufacturing an alternative, or supplement, to gasoline, while keeping CO2 emissions at roughly the same level. Gasoline engines can be modified to run on methanol at modest cost.”

Methanol is a liquid, clean, inexpensive, and domestic, transportation fuel for our new cars that can free us from our dependence on petroleum. Methanol can be America’s “Freedom Fuel.” Brazil reached energy independence with ethanol. China and Europe are already blending methanol into car fuels.

The Open Fuel Standard, H.R. 16876 is a two-page, bipartisan, bill that is pending in Congress and needs your support. It would:• create hundreds of thousands of jobs in America,• not cost the government or taxpayers anything,• cut our foreign trade deficit by more than half,• stop paying more in monopoly prices to OPEC that have damaged America by $8 Trillion since 1970, even without considering military, strategic and political costs, and• reduce some of another half a trillion dollars a year we spend protecting Persian Gulf oil supplies.

What the author is missing is that cheap natural gas has transformed the domestic ethylene industry. US ethylene was not economical using heavies as a feedstock, but cheap natural gas has made ethylene and its products coming from the USA competitive globally. Crackers on the gulf coast are rapidly being adapted to use ethane from natural gas as their feed. Shell is looking a building a cracker outside of Pittsburgh.

Cheap natural gas is truly transformational to the US ethylene industry.

Unless something changes dramatically in electric power generation, natural gas prices will soar. The only question is when. Obama's EPA has effectively banned all new coal-fired generating plants; and they are on the warpath to close our remaining coal plants. The future of nuclear power is highly uncertain with the likely loss of capacity over the next ten years. At some point, this must place a huge strain on natural gas supplies.

One important factor the author left out: the rest of the world is just getting started on using U.S.-developed drilling techniques (e.g. fracking and horizontal drilling). So the effective worldwide reserves are potentially vastly higher than current published estimates.

There's no doubt that in the short-run, the price of NG could stabilize or even move higher. But with energy categorically more expensive in the rest of the world (e.g. $8/gal. gasoline in Europe) and China and India in desperate need for lower-cost, lower-polluting energy to maintain their 7-8% growth rates, the pressure to find and exploit NG in non-U.S. regions is great.

In that context, $2.00/MMBtu natural gas may seem expensive in the future. Perhaps the smarter investment play is with companies that provide these drilling technologies to foreign energy producers. Perhaps a column for next week, Mr. Zweig?

Couple of points. Some have said electricity prices are not declining. At the wholesale level they are down dramatically, but not so much at the retail level. Basically a 50% drop in wholesale prices would show as 15% - 20% on your bill. NG figures into the wholesale costs.

Regarding the price bottom, it is true that prices this low encourage more natural gas consumption. In the short run principally for electricity generation, but to have a dramatic impact on demand new electricity and chemical plants need to be built. This takes years not days. Capping wells is easier said than done. There is a reason they keep pumping, read our white paper to see why. You can get it off my Linkedin profile (company Duxbury Energy). Right now there is just too much NG. This could of course change but it would require pretty dramatic reductions in supply or increase in demand. We will see.

Normally I agree strongly with Mr. Zweig, but this time I think he may have it backwards. With the discovery and recoverability of cheap natural gas resources perhaps it is the price of oil that is too high rather than the other way about.

I agree with the writers who are saying the more profitable play is in drilling, and transport.

"In mid-2008, natural gas traded above $10 per futures contract; today you can buy the equivalent for $2. The fuel is so cheap that if you could somehow magically transport it to Europe or Asia, you could sell it for four to eight times what you paid for it here."

The key word here is magic. Yes if you could magically convert natural gas to a convenient transport fuel (say methanol), you would be a billionaire many times over. Converting natural gas to methanol would easily rank in the top 10 scientific discoveries of all time if it could be done efficiently and on scale. Read more on this if you are interested in the science, it has always fascinated me that for all of chemistry's advances we still can't convert the simplest organic molecule into a convenient transport fuel.

Let me describe the situation in these terms: historical high investment chases a commodity that as a result tanks in price. Should you buy after the bust? I could be talking about the natural gas boom of the last several years, or I could be referring to the energy bubble of the late 1970's

Even after the bust in energy of the 1970's oil companies didn't beat the SnP in the following years. I would contend that natural gas is likely to be similar, prices will remain very low, some companies will survive, but overall you are unlikely to beat the market even though you have taken on above average concentration risk. The new advances in production have allowed us access to more natural gas than we need. I don't see that picture changing any time in the near future.

I could be wrong, just my 2 cents.

If you want to play NG I would buy a drilling and exploration company, like SLB. The starting quote shows how emerging markets would love NG at our prices. They could get it by investing in NG exploration to increase their reserves.

NG is the right call. The US has significant advantages at this resource and is exploring in different ways: NG is steadily replacing coal in power generation and diesel in heavy trucking. Americans are buying NG at a fraction of what people are paying overseas: Europe and Asia are paying about 4x and 7x compared to us. The problem is retail distribution. The recent NG price drop and higher oil price hopefully will offset our oil dependency.

If the progressives had any sense, they would pursue natural gas as the primary energy source. Making gasoline engines more efficient makes them more difficult and expensive to convert to NG. I'm thinking a better investment for now would be fuel transit companies. Pipelines, tankers, etc.

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if the progressives/liberals get 4 more years in the WH and control the Senate, then I'd think nat gas prices tighten higher as they'll do everything they can to thwart horizontal drilling, fracking, etc...

although it's seemingly a good idea, the impediments are: 1) extremely expensive to build numerous, large-scale plants across the country to change the supply mix, 2) EPA gone wild, 3) likely near impossibility to permit plants, 4) likely infrastructure changes/alterations to accommodate methanol (to include permitting...), 5) public policy that isn't based on energy economics, but rather partisan mud flinging...

until 1-5 are solved, it won't take hold...sad, but true...unfortunately...

and hopefully the nazis in the regime and the EPA won't stall the permitting of those plants...indeed, it should be a renaissance for the US domestic chemical industry...but we all know how well the EPA loves them :)

it will make future power prices increasingly volatile...now, maybe they are volatile upwards and maybe downwards...in the end, there's increased uncertainty...the strain will be felt not only on pipelines, but we'll need to build more pipelines, more market area storage, more compression to deliver the gas, more power plants sited at/near the demand source...so, more plants around cities (never a greenie favorite), more pipelines (NIMBY)...all in all, be sured that prices are more likely to increase than decrease given the proclivities of the left and their democrat wards...

we also did coal liquifaction and Sasol has done that for decades, along with the Germans during WWII...why not? it's billions to build 1 plant in an uncertain legal, EPA, and political environment...think about what Barry said about the coal industry...he was going to try and bankrupt you if you tried to build a new plant...now, whether he meant it or not, what company is going to risk billions to find out?

it's a simple solution to a simple problem...but then, the politicians got involved...and now it's a quagmire....what do you expect from lawyers and english majors? a firm grasp of economics??? ha!

the reason why ng is so cheap now is that a sudden increase in supply has not been met with rational outlets. once a few lng export terminals are built, the domestic price will rise to that of the loaded lng value less the costs of amortizing a lng export plant

b/c the installed capacity for power prices is predicated on coal fired generation. Given that nat gas is now cheaper than coal, but coal makes up ~52% of the generating capacity, power prices won't slip too much unless industrial activity continues to fall/stagnate...just b/c prices are low right now doesn't mean that consumers will feel it now. It would take years for additional nat gas generation to be installed and that would have a profound impact on the dispatch curve.

and, retail customers are on rate base. most of your bill will be "fixed," certaintly the physical energy is based on what your utility provider has to acquire it at on the open market or through long-term supply contracts. No US utility makes any money on the electricity or the natural gas supplied. They only make money on the transmission/distribution of those two...

"Even though fuel cost are decling due to low natural gas prices, base rates are increasing to pay for the build out of non economic reneable energy (particuarly wind) mandated by goverment."

That's true. Who can possibly believe obama's exhortations re ng when He, Chu and His other sandaled minions are doing their utmost to inflate energy prices by mandating renewables, which are so diffuse they can never carry baseload even if they eventually become economically competitive absent taxpayer subsidies. Ng is far and away the best interim fuel on the horizon for both electric power generation and transportation. It's a Godsend and people, the mkt, will react to its cheapness and abundance. It's even cheaper than coal per unit of heating value now. Who'd ever have thot that possible?

The only impediment I see is Obama and his cohorts running crying to the dimwitted judiciary, who know nothing whatever of energy engineering or economics, to mandate their stupid personal lib preferences re renewables.

I understand that he was granted the option to purchase 2.5% of each well through the Founder Well Participation Plan. He gets to choose the wells he where he exercises the option. Knowing which wells offer the greatest potential return is one of the best benefits of being the consummate insider.

He should have bought shares in the market so his interests are directly aligned with those of other shareholders. He didn't, and that leaves room for him to make money while the shareholders somehow get screwed.

Or perhaps just the opposite.. if Obama gets reelected, then he might be more motivated to slow play franking and LNG export regulations, to keep prices low for the consumer. If he doesn’t get reelected it will be easier for his friends at the NRDC and Sierra Club to press the issue through litigation as they won’t have to risk affronting one of their "supposed" biggest allies.

...like Dow Chemical, which apparently spends about $20 billion per year on NG as a feedstock for their various products. DOW has also lobbied heavily against subsidizing the use of NG as a transport fuel in the U.S. by arguing that low domestic NG prices benefit U.S. manufacturers, supporting U.S. manufacturing jobs, etc.

Not saying I agree with that - it's a heckuva calculus problem - but it does offer a counter to the, "well, of course we should run our cars on natural gas" argument.

So you think that the EPA should be disbanded then, because our squeaky clean fossil fuels industry can be wholeheartedly trusted to 'do the right thing?" The energy industry is the most powerful industry in the world. ThankGOD for the EPA is all I can say. Amazing to me how amazingly ignorant people like you are WORT.

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